Every year for the past two decades I have put together a portfolio of largely small-cap shares by following an approach based on the investment ideas of Benjamin Graham, and in particular from his seminal work, The Intelligent Investor. The aim is simple enough: look for companies that are “out of favour because of unsatisfactory developments of a temporary nature”, so their equity is priced well below intrinsic value.
Mr Graham’s approach was to focus on the balance sheet, and specifically the net current assets – stocks, debtors and cash less any creditors. He believed that a bargain share is one where net current assets less all prior obligations exceed the market value of the company by at least 50 per cent. His theory was that a strong balance sheet will usually see a company through any short-term difficulties; he called it his “margin for safety”. Of course, times have changed, and in today’s stock market very few companies meet such stringent criteria given that the link between market capitalisation and asset value has become more tenuous.
Indeed, when I ran my search in January this year, only a handful of the 1,700 listed UK companies had a bargain ratio of one or above and included a large number of illiquid micro-cap companies with market values below £10m that are incredibly difficult to trade. So, to widen the potential net of investment opportunities, I lowered the cut-off point and also considered companies with a market value above £20m to avoid liquidity issues. I then carried out a huge amount of equity research to create a manageable portfolio of 10 small-caps where the investment risk was skewed to the upside. I also considered the market environment and specific sectors and special situations which I felt would outperform no matter the equity market back drop.
It was well worth doing as my 2019 Bargain Shares Portfolio produced a total return of 28.8 per cent in its first six months to 31 July 2019, handsomely outperforming the FTSE Aim-All share index (3 per cent total return) and the FTSE All-Share index (10.8 per cent total return). It’s not a one-off either as 16 of my 20 annual Bargain Shares portfolios have beaten the FTSE All-Share index in their first year, delivering an average 12-month return in excess of 20 per cent.
|2019 Bargain Shares portfolio performance|
|Company name||TIDM||Market value||Opening offer price on 01.02.19||Closing bid price 31.07.19||Dividends||Percentage change|
|Litigation Capital Management||LIT||£106m||77.5p||97p||0.28p||25.5%|
|Mercia Asset Management||MERC||£100m||29.57p||33p||0p||11.6%|
|Jersey Oil & Gas||JOG||£45m||205p||206p||0p||0.5%|
|FTSE All-Share Total Return index||6,852||7,579||10.6%|
|FTSE AIM All-Share Total Return index||1,023||1,054||3.0%|
|Source: London Stock Exchange opening prices on 1 February 2019 and closing prices on 31 July 2019.|
Moreover, my 2019 Bargain Shares portfolio outperformed every single UK small-cap fund manager, according to Trustnet performance data using closing prices on 31 January 2019 to 31 July 2019 for all UK small-cap unit trusts, open-ended investment companies (Oeics) and investment trusts. The best performing investment company was Aim-traded Gresham House Strategic (GHS) which produced a 26.6 per cent share price gain in the six months to 31 July 2019. For good measure, I also advised buying shares in Gresham House Strategic at the end of 2018 (‘How Gresham House Strategic is outperforming’, 31 December 2018).
It’s worth noting that the average six monthly share price gain amongst the 22 UK small-cap investment trusts was only 3.6 per cent, only marginally ahead of the 3 per cent return on a FTSE Aim All-Share tracker. The average net asset value (NAV) return was 7.2 per cent with the latter ranging from a 16.9 per cent gain to an 8.3 per cent loss. On both measures, my 2019 Bargain Share Portfolio has beaten the small-caps investment trusts by a huge margin.
|UK Small-cap investment trust performance (31 January 2019 to 31 July 2019)|
|INVESTMENT TRUST||Alpha||Beta||Volatility||Sharpe||6-month return (%)||NAV 6 m (%)|
|Gresham House Strategic Plc 50P||28.65||1.1||16.84||1.03||26.6||10.3|
|Athelney Trust PLC Ord 25p||-10.53||0.18||30.51||-0.06||16.5||6.6|
|BlackRock Throgmorton Trust PLC||13.41||1.57||22.75||0||16.4||16.9|
|Strategic Equity Capital plc||9.92||0.87||13.1||0.1||15.6||12.8|
|Standard Life UK Smaller Companies Trust PLC||8.23||1.4||19.38||-0.01||12.7||12.8|
|Invesco Perpetual UK Smaller Companies plc||18.51||1.27||18.42||0.36||12.4||16.1|
|JPMorgan Smaller Companies IT plc Ord 5P||3.82||1.32||18.79||-0.01||11.1||13.0|
|BlackRock Smaller Companies IT||2.28||1.05||16.95||-0.01||9.4||10.7|
|Montanaro UK Smaller Companies IT Trust PLC Ord 2P||11.17||1.07||17.88||0.05||9.3||7.8|
|Henderson Smaller Companies Investment Trust PLC ORD 25P||-2.48||1.07||17.75||-0.02||4||7.0|
|Marwyn Value Investors Ltd Ord LD||-5.27||0.88||20.02||-0.03||3.2||3.6|
|River And Mercantile UK Micro Cap||-7.78||1.44||22.36||-0.04||1.4||6.0|
|Oryx International Growth Ltd||-2.4||0.38||7.17||-0.01||0.3||11.2|
|SVM UK Emerging||10.8||1.57||42.3||-0.03||0.3||6.5|
|Odyssean Investment Trust Plc Ord 1P||-2.08||0.43||8.01||-0.01||0.2||9.9|
|Aberforth Smaller Companies Trust plc Ord||-6.45||0.9||14.43||-0.02||-0.5||2.9|
|Aberforth Split Level Income Trust PLC Ord 1P||-12.41||1.01||22.5||-0.05||-6.1||3.2|
|Crystal Amber Fund Limited Ord 1P||-0.11||0.42||16.44||-0.01||-6.8||14.8|
|Rights & Issues Investment Trust Inc||-4.21||1.11||16.36||-0.02||-6.9||-3.5|
|Chelverton Growth Trust plc||-18.97||0.24||8.53||-0.02||-10.3||2.0|
|Downing Strategic Micro-Cap Investment Trust Plc Red Ord GBP0.001||-21.36||0.49||7.99||-0.02||-11.1||-2.4|
|Miton UK MicroCap Trust PLC Ord||-19.48||1.16||19.21||-0.05||-18.1||-8.3|
|Source: Trustnet data. Closing market prices 31 January 2019 to 31 July 2019.|
That margin is even greater for the 51 UK small-cap funds and OEICS in the universe that produced an average six monthly gain of 2.8 per cent. The median return was 7.5 per cent, ranging between a positive return of 25 per cent for the TM Cavendish Aim B fund to a 10 per cent loss for the LF Miton UK Small Companies B fund.
Importantly, there are reasons why my investment strategy and stock selection outperformed so well, not to mention why this investment approach continues to stand the test of time.
Reasons for outperformance
One reason for the ongoing outperformance is that I take a macroeconomic view as well as drilling down into the micro company details in order to select small-caps that are likely to outperform.
Indeed, at the start of the year, I set my stall out believing that the volte-face by the US Federal Reserve in December 2018 to effectively call a halt to its monetary tightening policy (which had until then been on auto-pilot and had led to the heightened risk aversion in the fourth quarter of 2018) would support a rally in precious metals from heavily oversold conditions (‘A game changer’, 7 January 2019). I also believed that equity markets would rally, too, as the equity risk premium embedded in valuations was likely to unwind ('Profit from unwinding of recessionary risk', 21 Jan 2019). My thesis has panned out which explains why US equity markets subsequently made all-time highs and even in the UK, a market dogged by a Brexit discount, the FTSE 350 index got to within 3 per cent of hitting its May 2018 record high.
I therefore wanted to focus on companies that would benefit from a ‘risk-on’ environment and ones that also offered scope to accelerate returns by concentrating on special situations that were already being significantly undervalued, thus creating a ‘margin of safety’ in the event of the rally running out of steam.
Of course, not all the companies in my 2019 Bargain Shares portfolio have produced bumper gains. But the fact that shares in seven companies have overdelivered, and only one is under water, highlights the gains that can be made by building in a large ‘margin of safety’ when stockpicking.
Screening for small-cap bargains
Futura Medical (FUM), a pharmaceutical company that is developing a portfolio of innovative products based on its proprietary, transdermal Dermasys drug delivery technology and one that is focused on sexual health and pain, fitted the bill nicely at the start of the year.
The company’s share price had been beaten down to bargain basement levels, so much so that Futura only had a market capitalisation of £30m, a valuation completely at odds with the huge potential commercial value of its flagship product, MED2005, a breakthrough topical gel for erectile dysfunction (ED), which is currently going through a Phase III clinical trial. The prospect of positive news flow being released this year (as has been the case), and investors turning their attention to the commercial upside from the product if the trial data delivers what potential partners are demanding, has sent Futura’s share price soaring.
For good measure I also flagged up a repeat buying opportunity just below my original 14.85p entry level in mid-April (‘Futura’s blue sky opportunity’, 14 April 2019), since when the share price has almost trebled. There is potential for significantly more share price upside, too. That’s because analysts at heavy weight broking house Liberum Capital rightly point out that the Phase III clinical trial is not a binary event. In fact, there are 20 realistic outcomes of which only one would definitely mean MED2005 cannot be launched commercially. Futura de-risked the trail by increasing the sample size, expanding the trial duration and adding two higher doses. MED2005 has a rapid rate of glyceryl trinitrate (GTN) absorption, with first detection in blood plasma in four to five minutes, reaching peak levels in the bloodstream within 10 to 12 minutes for all doses, far quicker than any oral inhibitor on the market (60 to 120 minutes to reach peak levels) and without the nasty side effects either.
In the least optimistic scenario, Liberum estimate MED2005 peak annual sales of £230m by 2028, rising to £500m in the most optimistic case. These seem sensible forecasts to me given that there are an estimated 78m men above the age of 40 with some form of ED in the US and the EU5 (France, Germany, Italy, Spain, United Kingdom) who between them currently generate $2.4bn (£2bn) of annual sales for the manufacturers of oral inhibitors (Viagra, Cialis and Levitra).
Furthermore, at least 10 per cent of patients are unable to take oral inhibitors because they are on nitrate therapy, so would benefit from MED2005. It’s worth observing, too, that the Massachusetts male Ageing Study published in 1994 found that 52 per cent of men above the age of 40 had some form of ED. Given the ageing population, the target group of men suffering from ED can be expected to grow by between 1.5 to 2 per cent per annum until 2030.
In terms of the target market, annual sales of oral inhibitors currently generate around $2.4bn of annual sales at $3 per pill, implying 800m doses each year. Even if Futura only captured 10 per cent of this market, then based on a manufacturing cost of 33¢ (28p) per dose and retail price of around $5 (£4.13) – and it could be higher – clearly there is a huge profit to be earned at an eye-watering 93 per cent gross margin. The product is patented protected, too, so Futura should have exclusivity until 2030 from first approval.
The point being that even though Futura’s market capitalisation is now £87m, or three times the level at the end of January 2019, then it’s really not difficult to arrive at Liberum’s target price of 60p, implying a market capitalisation of £124m, or its blue sky fully de-risked target of 137p, implying a target market capitalisation of £280m. To put the blue-sky target into some perspective, and assuming Futura signs an outlicensing deal, then based on peak annual sales of £500m, the company could expect royalties of £100m plus per year.
So, having last advised buying the shares at 30p a couple of months ago ('Futura’s huge potential draws investor interest', 20 June 2019), I feel that the share price rally this year has still a long way to go. Buy.
Targeting companies that benefit from easing of monetary policy
I also thought that any easing of monetary policy in a more benign investment climate would be good news for venture capital funds focused on technology companies, and in particular: TMT Investments (TMT), a venture capital company that invests in high-growth, internet-based companies across a variety of sectors – and with a significant number of Silicon Valley investments in its portfolio; and Augmentum Fintech (AUGM), the first publicly listed fintech fund in the UK when it listed its shares on the London Stock Exchange in March 2018. I assessed the value of every single one of their investments and concluded the investment risk was materially skewed to the upside.
For instance, TMT owns a valuable 1.7 per cent stake in Bolt (bolt.eu), a leading international ride-hailing company, which has since soared sixfold in value to $22m (£18.3m) in the past year following a series of funding rounds. There have been many other positive uplifts, too, across TMT’s portfolio including the disposal of its stake in Wrike (www.wrike.com), the collaborative work management platform that provides workplace teams with a single digital platform to maximise their operational performance. The $22.6m sale proceeds represents an eye-watering return on the $1m TMT invested in June 2012. So, even though TMT’s shares now trade at a premium to net asset value, I am not cashing in yet as I still see material valuation upside to what are conservative accounting carrying values of its investee companies (‘TMT Investments banks massive gains on asset disposals’, 4 July 2019). TMT is also rewarding shareholders, having recently paid out a 20¢ a share dividend.
Augmentum has been delivering eye-catching investment gains, reporting an annualised internal rate of return (IRR) of 28 per cent since IPO, buoyed by gains on its two largest holdings: Zopa, the world’s first peer-to-peer consumer lending platform; and Interactive Investor, a leading UK investment platform. I fully expect further valuation uplifts as do investors who recently backed a placing of new shares ('Investment company watch', 9 July 2019). Indeed, Interactive Investor’s carrying value in Augmentum’s accounts is based on a earnings multiple that represents a deep discount to listed peers AJ Bell (AJB) and Hargreaves Lansdown (HL.). It’s not the only one of Augmentum’s holdings that has potential to deliver material gains either. For example, the company has recently invested £5m in Tide (tide.co), an emerging force in the SME challenger banking sector; £2.5m in Monese (monese.com), the UK based fast-growing mobile-only current account provider; £1m in DueDil (duedil.com), a predictive company intelligence platform; and £5m in Habito (habito.com), the UK’s only on-line mortgage broking and lending platform.
I also believed that an interest rate environment where an increasing amount of government bonds yields were likely to turn negative – there are now more than $13 trillion of sovereign bonds with negative yields – would be a positive for technology stocks as these are more sensitive to interest rates given that discounted cash flow methodology is more commonly used in their valuations. That’s because as long-term yields fall, so too does the discount rate applied to tech companies future cash flows which means that the discounted value of these cash flows is worth more in today’s money. This is clearly positive for TMT and Augmentum’s portfolio of technology companies, and for Mercia Asset Management (MERC), too, an investor and fund manager focused on funding and scaling of innovative UK technology businesses with high growth potential.
I took the view that Mercia would start to sell down its longer held investments later this year, thus realising potentially large gains and thus attracting greater investor attention. That possibility is still not in the price, as the shares, at 34p, are trading 20 per cent below net asset value. Also, Mercia’s fast growing and highly operationally geared fund management business is effectively thrown in for free as I pointed out when I covered the annual financial results. I maintain my sum-of-the-parts valuation of £146m, or 48p a share ('Mercia aims to double assets under management to £1bn within three years', 8 July 2019).
Playing a free option on the gold price
The surge in precious metals prices is a major positive for Ramsdens (RFX), a diversified financial services company whose main activities encompass foreign currency exchange, retail jewellery, pawnbroking and a precious metals buying and selling service. When I launched my portfolio after the close of trading on 31 January 2019, I noted that the gold price had been rising strongly, and at £1,012 an oz was only 14 per cent below the September 2011 all-time high of £1,182 an oz that was hit during the eurozone banking and credit crisis. The gold price is now £1,243 an oz and making new all-time highs much as I had predicted would happen ('A golden opportunity', 24 June 2019).
The point being that the profits Ramsdens earns from precious metals buying and scrapping unredeemed pledges (a combined four fifths of the company’s total gross profit in the 2018/19 financial year) should be getting a major boost. So too will be the interest income earned from the pawnbroking pledge book as the company can make larger loans to its customers given the higher value of the assets being pledged, a large chunk of which are gold jewellery items. In addition, a high percentage of the increase in gross profit earned from precious metals buying drops straight down to the bottom line in a rising gold price environment, so in effect we are getting an option on a rising gold price thrown in for free (‘Playing the precious metal complex’, 29 July 2019).
It’s worth considering that Ramsdens generates almost four fifths of its gross profit from providing foreign currency exchange, which provided £496m of currency at market leading rates to 832,000 of its customers in the 2018/19 financial year. Bearing this in mind, the absence of the long hot summer which led to a ‘staycation’ culture in 2018 and subdued earnings on this side of the business, coupled with the fall in sterling in 2019 which means Ramsdens’ currency customers will need to exchange more sterling to maintain their spending power on their overseas holidays, is likely to have boosted divisional profits.
The potential for an earnings beat is simply not being factored into the current valuation with Ramsdens’ shares trading on a modest cash-adjusted price/earnings (PE) ratio of 8.5, well below that of rival H&T (HAT), a constituent of my market beating 2017 Bargain Shares portfolio and another company I am keen on.
Playing the litigation game
I made a conscious decision to hunt out an undervalued litigation funding company that was set to deliver a raft of positive news on case settlements, principally because the asset class has uncorrelated returns with equity markets, so acts as a portfolio diversifier. The company that fitted the bill was Litigation Capital Management (LIT), a Sydney-based provider of litigation financing to enable third-parties to pursue and recover funds from legal claims.
As I noted in my update a few weeks ago ('Investment company watch', 9 July 2019), the company has been making strong operational progress. Importantly, Litigation Capital holds its litigation investments at their cash value on its balance sheet, unlike others in the sector, so its net asset value is based on conservative accounting. It also understates the true underlying value of the litigation cases given that the company has generated a cumulative average return on invested capital (ROIC) of 117 per cent on all settled cases since 2012.
The 10 per cent markdown in Litigation Capital’s shares this month following the bear raid onBurford Capital (BUR), the market leader in the litigation funding sector, presents an obvious repeat buying opportunity. Indeed, conservative accounting and the ability to generate a mid-teens post-tax return on equity in the 2019/20 financial year explains why my fair value target of 140p is more than 50 per cent above Litigation Capital's current price. The shares are also only rated on a price/earnings (PE) ratio of 11 for the 12 months to end June 2020, and on a modest 2.3 times forecast book value even though Litigation Capital is in a healthy net cash position to be able to invest in potentially lucrative litigation cases.
Planning for bumper profits
Another key decision I made to diversify the portfolio was to target companies that make their money from the planning process. That’s because, irrespective of which political party controls the Houses of Parliament, the need to build an increasing number of new houses to meet the demands of a growing population will be positive for these companies.
Inland Homes (INL), a leading brownfield developer, housebuilder and partnership housing company with a focus on the south and south-east of England, was an obvious selection as I thought there was a high probability of the company gaining planning consent this summer on two major development projects: its flagship site at Wilton Park, Beaconsfield ('Inland wins major planning consent', 10 June 2019); and a new urban village of 1,725 homes at Cheshunt Lakeside, Hertfordshire.
As a result of these two successful planning awards, I anticipate Inland’s last reported European Public Real Estate Association (EPRA) net asset value (NAV) of £213m (103.6p a share) to rise sharply when the company releases a pre-close trading update in early October 2019. The point is that there was a massive ‘margin of safety’ in Inland’s valuation back in late January, and there still is for that matter, one reason why I expect the shares to continue to make headway as more investors cotton onto the valuation discrepancy, and the company starts to realise bumper land sales.
Market risk to portfolio
Interestingly, although the US Federal Reserve Open Market Committee (FOMC) delivered the well telegraphed 0.25 per cent point cut in the Fed Funds rate that the market had been anticipating, the US equity market sold off post the announcement on Wednesday, 31 July 2019. This was partly because US central bank chairman Jay Powell initially indicated that the cut was a ‘mid-cycle adjustment to policy’, rather than the start of full blown rate cutting cycle. It's worth noting though that the US futures market is pricing in a 60 per cent chance of a further 0.25 per cent point interest rate cut at the September FOMC meeting, so the smart money is betting that last month’s cut – the first for 11 years – is likely to be more than just a one-off.
However, I feel that the key reason for the ‘risk off’ investor sentiment this month has been the escalation in trade tensions between the US and China, sparked by President Trump threatening to impose higher tariffs on US$300bn (£248bn) of imports. China effectively retaliated by allowing its currency to drop below the key level of US$1: ¥7 support level, effectively making the country’s exports cheaper and a deflationary move that will not be welcomed by key western markets.
That said, US equity markets were well overdue a summer breather given the sharp run up this year which had seen the S&P 500 index rise by 21 per cent and the tech laden Nasdaq Composite index post gains of 25 per cent. It’s more of a case that President Trump has supplied the catalyst for one as we entered August, a month which has a mixed record. For instance, in the UK, the FTSE All-Share index has posted an average loss of 0.28 per cent during the month of August in the past decade, but this masks some hefty reversals including a 6 per cent monthly loss in 2015 and a 7.6 per cent loss in 2011.
Interestingly, my 2019 Bargain Share Portfolio has performed well during the August market sell-off, actually increasing in value by almost one per cent since the close of trading on 31 July 2019. This compares favourably to the 4 per cent fall in the FTSE All-Share Total Return index and the 5 per cent drop in the FTSE Aim All-Share Total Return index during the same period. The ongoing outperformance also highlights that by taking a disciplined approach to investing, and hunting out value opportunities that are deep into bargain basement territory, it is possible to outperform the market indices even when market conditions are less benign.
|2019 Bargain Shares portfolio performance|
|Company name||TIDM||Index||Market value||Opening offer price on 01.02.19||Bid price 12.08.19||Dividends||Percentage change|
|Litigation Capital Management||LIT||Aim||£96m||77.5p||88p||0.28p||13.9%|
|Jersey Oil & Gas||JOG||Aim||£44m||205p||200p||0p||-2.4%|
|FTSE All-Share Total Return index||6,852||7,302||6.6%|
|FTSE AIM All-Share Total Return index||1,023||1,003||-2.0%|
|Source: London Stock Exchange opening offer prices at 8am on 1 February 2019 and bid prices at 9.50am on 12 August 2019.|
The long-term gains can be tremendous, too, as followers ofAB Dynamics (ABDP), a designer, manufacturer and supplier of advanced testing systems and measurement products to the global automotive industry, will testify. I included the company’s shares, at 173p, in my2015 Bargain Share portfolioand they have subsequently risen by 1,380 per cent to 2,560p. AB Dynamics was under researched and under the radar of investors four and a half years, thus offering an opportunity to buy into a long-term growth story at a very favourable entry point. There are many other examples, too, which is why my annual Bargain Shares Portfolios have managed to beat the market so consistently.
For example, MJ Gleeson (GLE),the low-cost housebuilder and strategic land specialist has paid out cumulative dividends per share of 100.5p since I included the company in my market beating 2012 Bargain Shares Portfolio. Moreover, the company’s share price has soared almost eight-fold from my 110p entry point seven and a half years ago to 850p. I also included East London housebuilder Telford Homes (TEF) in that year’s portfolio, too, at the bargain basement price of 91.7p. Telford has since paid out total dividends of 90.1p a share and has attracted a recommended cash takeover bid worth 350p a share from real estate group CBRE.
Takeover activity is a recurring theme amongst the constituents of my Bargain Shares Portfolios. That’s hardly surprising given that the companies I target are undervalued ‘value’ plays, so some are likely to attract the attention of predators. I wouldn’t discount the possibility of mergers & acquisition (M&A) activity emerging in this year’s portfolio either, thus providing another potential catalyst for the ongoing outperformance.
Simon Thompson has been named 2019 Small Cap Journalist of the year at the 2019 Small Cap Awards, a prestigious event celebrating the best and rewarding the finest professionals and companies that work within the AIM and NEX communities. It is attended by institutions, fund managers, brokers and advisors operating in the sub-£100m market cap quoted company sector.
■ August promotion. Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £3.25 [UK].
For a limited period, both books can be purchased for the promotional price of £25 plus UK postage and packaging of only £3.95. Details of the content of both books can be viewed on www.ypdbooks.com. Both books include case studies of Simon Thompson’s market beating Bargain Share Portfolio companies outlining the investment characteristics that made them successful investments. Simon also highlights many other investment approaches and stock screens he uses to identify small-cap companies with investment potential, too.